Hope you had read the 1st Part of the Stock Gyan series, if not, click here to read it.

Today, we will discuss about the types of Financial Instruments:

As already mentioned in the previous part, the financial instruments are categorized into 2 parts:

Debt based Instruments

Equity based Instruments*

Let’s come to Debt based instruments:

Read carefully otherwise it may slip and go above your head.

Now, understand one thing that Debt is a class of asset which is further classified on the basis of following:

Securities

Other cash*

Exchange traded derivatives*

OTC derivatives*

Let’s discuss each of the above in detail:

Long term debt in the form of Securities

Meaning of securities:

These are the investments that can easily be bought or sold on the open market. The high liquidity of marketable securities makes them very popular among individual and institutional investors.

Type of securities in long term debt asset class:

When we are talking about the long term debt securities, then that are called Bonds

For example: If you want to invest in Long term debt securities then that means you are investing in Bonds or you can invest in Bonds.

Meaning of Bonds:

A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt-holders, or creditors, of the issuer.

For example: ABC Pvt. Ltd. Company need some funds for the completion of his project but it don’t want to take loan from Bank because of xyz reasons. In that case it can issue Bonds to the public who will purchase the bond of the company after paying g the specified amount. The purchaser will become the debt-holder or creditor of the company.

Benefit of purchasing Bonds:

The purchaser gets the Coupon along with the bond, according to which the purchaser gets the interest amount on the date of that maturity along with the principle amount. The interest rate is mentioned in the coupon.

Types of Bonds:

The classification of bonds depends upon various factors like issuer, priority, redemption features and coupon rates. Let us take a look at the various types of bonds:

Government Bonds

Corporate Bonds

Zero Coupon Bonds

Junk Bonds

Tax Saving Bonds

Government Bonds:

A government bond is a bond issued by a national government, generally with a promise to pay periodic interest payments and to repay the face value on the maturity date. Government bonds are usually denominated in the country’s own currency.

In India, the government bonds are classified as tax free bonds which include some of the famous tax free bonds trending in the markets such as:

State Bank of India SBIN-N6

National Highway Authority of India NHAI-N1

Rural Electrification Corporation Ltd RECLTD-N9

State Bank of India SBIN-N5

Working of Tax free/Govt. Bonds:

Tax free bonds are usually issued for a period of 10 – 20 years or even more than that. They are also listed on stock exchanges to offer an exit route to investors. The bonds are tax-free, secured, redeemable and non-convertible in nature. Trading in these bonds can be only done through Demat accounts.

Taxability of Tax Free Bonds:

Confused???????

You might be wondering after reading the above heading that why taxability when the bonds are tax free. Try to understand this with the help of an example:

Suppose one of your friends lend you 500 rupees without any interest for meeting your household expenses but instead of using that money for bearing your expenses, you further lend that money to some other person @10% interest rate. After 1 month you got the money back with interest. Subsequently, you visited your friend’s home for returning the money back and then you also told him regarding interest income. After listening to your words, your friend asked for the share in the interest income and that was absolutely right because he gave you the money for fulfilling your need and that too without any interest.

Same has happened in this case, Govt. has issued bonds for investment but if some people start selling it to others for profit then definitely govt. will ask for his share in that profit (capital gain) from that sale of bonds.

Therefore, If there is any capital gain on transferring them on exchanges, that will be taxed. If the holding period is less than 12 months, capital gains on sale of tax-free bonds on stock exchanges are taxed as per the tax rate of the investor. If bonds are held for more than 12 months, the gains are taxed at the rate specified by Income Tax Act, 1961. There will not be any benefit of indexation in them.

Why to invest in these bonds?

No Risk: These bonds are issued by the govt. ,That’s why these are called risk free bonds and people feels it safe to invest in these securities.

Tax Exemption: As these are Tax free bonds, there is no taxability on interest income earned from these bonds. However, capital gains will be taxed if any (explained above)

Effective Pre-tax yield: Pre tax yield is the rate of return on an investment before taxes have been considered. As with other measures of yield, pretax yield is usually stated on an annual basis.

Be careful before investing in tax free bonds…..

There are some factors which must be considered once before investing in these bonds:

Long Tenure: The tenure of these bonds are very long ranging from 10 years to even more than 20 years. So, one must obtain the complete information regarding the tenure of bonds in which he is investing.

Low Liquidity: These securities do not offer good liquidity feature that means it is not easily convertible into cash. Usually, they are listed on stock exchanges to provide an exit route to investors.

Annual Interest: The frequency of interest rate in these bonds are generally annual. Unlike others, the interest is not always credited bi-yearly (6 monthly). In some cases, the interest is credited after 6 months i.e. twice a year but interest rate is generally reduced by some percent in that cases.

Corporate Bonds

Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. When one buys a corporate bond, one lends money to the “issuer,” the company that issued the bond. In exchange, the company promises to return the money, also known as “principal,” on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually.

Investment in these bonds are more riskier than investing in govt. bonds but on the other side, these bonds offers high rate of return to its investors which attracts them to invest in these bonds.

Reason for issuing there bonds

Corporate bonds are a form of debt financing. They can be a major source of capital for many businesses, along with equity, bank loans and lines of credit.

Working of Corporate Bonds:

Corporate bonds are issued in blocks of $1,000 in par value, and almost all have a standard coupon payment structure. As the investor owns the bond, he receives interest from the issuer until the bond matures. At that point, the investor can reclaim the face value of the bond. Corporate bonds may also have call provisions to allow for early prepayment if prevailing rates change, and investors may also opt to sell bonds before they mature.

Yields (Earnings):

Yield is a critical concept in bond investing, because it is the tool used to measure the return of one bond against another. It enables one to make informed decisions about which bond to buy. In simple words, yield is the rate of return on bond investment.

However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates.

Example of Yield working:

You buy a bond, hold it for a year while interest rates are rising and then sell it.

You receive a lower price for the bond than you paid for it because, no one would otherwise accept your bond’s now lower-than-market interest rate.

Although the buyer will receive the same amount of interest as you did and will also have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours, because the buyer paid less for the bond.

Yield is commonly measured in two ways, current yield and yield to maturity.

Current yield

The current yield is the annual return on the amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par-value bond paying 6% is 6%.

However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a Rs. 1,000 bond with a 6% stated interest rate at Rs. 900, your current yield would be 6.67% (Rs. 1,000 x .06/Rs.900).

Yield to maturity

It tells the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realize (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).

Valuation of Corporate Bonds:

There is inverse relationship between bonds and interest rates—bonds are worth less when interest rates rise and vice versa .

Why inverse relationship?

When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down.

As a result, if one sells a bond before maturity, it may be worth more or less than it was paid for.

By holding a bond until maturity, one may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because one will receive the par, or face, value of the bond at maturity.

Some Popular Corporate Bonds:

Housing and Urban Development Corporation

ECL Finance

India Infoline Finance

Indian Railway Finance Corporation Series

Muthoot Finance

Zero Coupon Bonds

The name itself describes what these bonds are. Yes, you got it right, these bonds do not provide benefits of coupon to its investors and no coupon is equal to no interest. These are generally issued for long term, at least 10 years.

Isn’t it sounding something illogical? Because if there will be no benefit then why will one invest in this?

Let’s discuss.

A zero-coupon bond, also known as an “accrual bond,” is a debt security that doesn’t pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.

That means there will be profit on maturity. Secondly, zero coupon bonds are actually not a zero coupon as the companies take out their coupons but pay the together at maturity with principle amount.

But, there is one problem. If the coupons are paid at the end then that doesn’t means that the income will also accrue at the end.

No. Not at all, the income will be accrued at the time which is mentioned in the coupon and accordingly, the investor have to pay tax on accrued interest income.

For example: if the coupon states that interest will be credited on 10th of june, 2017 but the company decided to pay the amount at maturity with the principle amount in june 2025, then in that case the income will be deemed to be accrue on account of interest income and therefore, the point of taxability will arise.

The advantage of investing in these bonds is the fulfillment of long term goals which can be easily managed as the money will be received at some future date.

For example: one can invest in these securities for meeting out the future education expenses of his/her children.

Junk Bonds

For understanding of these bonds, you have to go through the following example:

Suppose there are 2 companies in the industry ABC Private Ltd. And XYZ Private Ltd.

They both has invited public to purchase their bonds but the track record of ABC ltd. Is far much better than XYZ ltd. In terms of their credibility of payment, previous records. So, after analyzing maximum people will purchase the bonds of ABC ltd and due to this the bonds will become low traded bonds in the market and that’s why they are termed as Junk Bonds.

Why to invest in Junk Bonds?

Junk bonds are risky investments, but they have speculative appeal because they offer much higher yields than bonds with higher credit ratings. Investors demand that junk bonds pay higher yields as compensation for the risk of investing in them. If a junk bond manages to turn its financial performance around and has its credit rating upgraded, the investor may see a substantial appreciation in the bond’s price.

Rating System:

Bonds are rated based on the revenue they generate to make principal and interest payments, and based on any assets pledged to secure the bond. The more revenue a bond can generate, the higher the credit rating.

Secured & Unsecured Junk Bonds:

A secured bond uses specific assets that serve as collateral, and in case of no profit, that asset can be sold to make principal or interest payments if any payments are missed.

Unsecured bonds, on the other hand, depends upon the payment capabilities of the issuer.

The credit rating is effected a lot by the payment capabilities and the types of assets charged for the payment.

Defaults:

Because junk bonds have a high default risk, they are speculative. Default risk is the chance that a company will be unable to pay its obligations when the bonds mature. Even when a junk bond defaults, it might still keep some of its value.

Tax Saving Bonds

The name itself says, the bonds which provide the benefits to owner in respect of savings in tax are called Tax Saving Bonds.

Section 80CCF of the Income Tax Act, 1961 states In computing the total income of an assessee, being an individual or a Hindu undivided family, there shall be deducted, the whole of the amount, to the extent such amount does not exceed twenty thousand rupees, paid or deposited, during the previous year relevant to the assessment year beginning on the 1st day of April, 2011 or to the assessment year beginning on the 1st day of April, 2012, as subscription to long-term infrastructure bonds as may, for the purposes of this section, be notified by the Central Government

Don’t misinterpret the Tax Saving Bonds as Tax Free Bonds as they both are entirely different. Tax free bonds means Zero/Nil tax whereas Tax Saving Bonds helps in saving a little of our money to be paid as tax.

*These will be discussed in further parts of the Stock Gyan series

In this part we had discussed fully about the “Security” category of long term debt asset class which includes “Bonds”.

For more parts, stay tuned to www.atulkhurana.com. Don’t forget to share this useful info with your friends.

In the next part we will discuss about the further categories of Long term debt asset class i.e.

Other cash

Exchange-traded derivatives

OTC derivatives

So, don’t miss it.

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